Understanding Life Insurance

Life insurance is based on the statistical odds that one person among a group of insureds will die. Life insurance is simply a group of people sharing the same risk and funding the dollars needed when a member of the group dies, which gives rise to the analogy of a lottery winner—only in this case—eventually, everyone wins. The first to die are paid by the last to die. So, let’s consider a group of a thousand men who are each 45 years old. Insurance company mortality tables assume that they are all in good health today, but project that none will live to age 100. The mortality chart shown in Table 5-1 predicts the chances of a person’s death in any given year between ages 45 and 100.

Let’s assume the money earns no interest. If all participants die according to statistical probability, and each member contributes the appropriate amount, there will be enough funds to pay each participant’s beneficiaries his or her share of the account. Those who die early will benefit most on the basis of the ratio of their contribution to the proceeds. Those who die later will still receive proceeds, but they will have paid more compared to those who died early.

When interest earnings are factored in, the last to die will still have to pay more into the fund than the first. However, the compound interest earnings will offset the need for them to place the full value of their expected benefits into the pot.

The Cumulative Cost

Many people don’t count the cost of insurance over an extended period of time—they only focus on the cost today! However, what happens when you add up the total cost of insurance (the mortality costs) from today until life expectancy?

Assume you are part of a group of 45-year-old males. The sum of the mortality costs to life expectancy is 74.7 percent of the face amount for a 45-year-old male. So, if you wanted to own $1 million of insurance starting today and you paid the annual mortality costs every year until your life expectancy, you would pay $747,000.

This cost has been measured for over 20 major insurance companies and the cumulative rates all come out within dollars of each other. Actuaries (the mathematicians trained to calculate the cost of insurance) all work from the same base of statistics. Every insurance carrier must mathematically be near the same target; a carrier that isn’t has violated the fundamental theory of risk sharing.

But let’s look at what happens if you are unfortunate enough to live until two-thirds of the initial group is dead. This is called the first standard deviation from the mean. The standard deviation is the next statistical breaking point from the average age of death (usually 6 to 8 years later). Let’s add up all the mortality costs for $1 million of insurance at one standard deviation. The total equals 119 percent of the face amount. That’s right—you would have to pay $1,196,000 for $1 million of coverage if you died at the two-thirds point.

It gets worse. What if you should live two standard deviations (when 95 percent of the group is dead) beyond the mean? The ratio of mortality costs to benefits increases to 240 percent. That means you have paid $2.4 million for $1 million of insurance. It’s expensive to live a long time if you want to retain your insurance.

Consequences of Aging

What would you do if you were 80 years old and your insurance premium notice came in the mail telling you to pay $150,000 this year for your $1 million policy? Most people would say they wouldn’t pay it and would throw the notice away. They would let the policy lapse and laugh at the absurdity of paying $150,000 that year. However, let’s change the scenario. Suppose you just came back from your physician and knew you had only 6 months to live. Now what would you do?

The ability to choose to keep your policy on the basis of health conditions creates adverse selection against the insurance company. Deciding whether to keep the insurance solely on the basis of probability of death ruins the mathematical principle. Insurance must have statistical randomness to protect the integrity of the product. There must be an incentive for healthy insureds to stay in the pool.

In the early 1800s, only people who were near dying retained insurance. And because there were no healthy insureds left to pay premiums, what happened? If you guessed bankruptcy, you are correct. Virtually all insurance companies now in business started after 1820. That’s because so many of the older companies went out of business due to this adverse-selection problem. So the insurance companies called in the actuaries and told them to solve the problem. The actuaries sat with their abacuses and determined there was only one solution—the box.

The Box

The actuaries developed a solution that made retaining lifelong insurance possible: Insurance companies had to help insureds prefund their insurance premiums so they could afford to retain their coverage throughout their lives. As you have seen, if they only offered insurance premium plans on a pay-as-you-go basis, no one would ever be able to keep his or her insurance in old age.

That’s where the box comes in. The box is an individual account in an insurance policy. It holds all the premium payments the insured makes. From the box, the insurance company pays the annual cost of insurance (mortality costs) and policy expenses.

Unfortunately, the cost of funding the box without interest was still too expensive. So the actuaries had to add an interest element to the box. The insurance company invests the premiums it receives (net of expenses) and then allocates the net earnings to the box after management fees. The amount allocated varies according to the insurance contract.

In 1913, Congress passed the Sixteenth Amendment, authorizing the collection of income taxes. The insurance industry successfully sought regulatory relief to allow the money in the box to grow without tax. Thus, the government actually subsidizes the cost of insurance as a contribution to the welfare of society.

Box Designs

Once the concept of the box was developed, insurance carriers began to design different configurations. A policyholder could purchase an insurance contract, which required premiums for specific periods, say, 20 years or until age 65. As the market developed different needs, the carriers responded with appropriate policy designs. One type is called whole life. The premiums are fixed on the basis of a guaranteed interest rate the carrier is offering in the box.

Any excess interest earnings, adjustments to mortality experience and expense loads are credited and debited to the box through dividends. These dividends combine the earnings and costs together in one amount. This is often referred to as the bundled approach.

In the 1980s and 90s, most insurance carriers expanded their portfolios to include a product that allows the policyholder to determine the amount of premium and frequency of payment. This policy is called universal life. Although universal life can be mathematically designed to look more favorable than whole life (you pay a lower premium for the same coverage, for example), remember that the box still needs the same amount of money to accomplish the same objective over the same period of time.

It is important to understand that, if all the assumptions for whole life and universal life are the same (i.e., mortality table, expense loads and interest credit rate), the cost should be the same and the outcome should be the same. With whole life, there is little control over these assumptions and the premium is fixed according to the guaranteed interest rate in the contract.

With a typical universal life policy, the premium is based on the projected interest rate over the lifetime of the policy contract. If the guaranteed rate is 4 percent for a whole life contract and the projected rate is 6 percent for the universal life contract, then the annual premium you would pay will be lower for the universal life policy. Why? It is assumed that the higher interest earned in the box will make up the difference in premium deposits. However, when you factor in the dividend credit for the whole life policy, which will match the 6 percent performance of the universal life policy, both approaches should end up economically the same.

The main difference between whole life and universal life is the flexibility the policyholder has to skip premiums if he or she can’t afford to pay them in one or more years. However, this freedom may ultimately jeopardize the goal of lifetime coverage if insufficient premiums have been deposited—this would defeat the entire purpose of using the box in the first place.

If the projected lump-sum value of the box falls below the target, the insurance carrier is unable to fulfill the terms of the contract. Either the policy will be discontinued or the annual funding amounts will need to be increased. This is true for both universal and whole life policies, although individual companies deal with the problem differently.

If you have a whole life policy, you can be underfunded if you borrow too much from the box, fail to pay the interest on the policy loans or fail to pay your scheduled premiums.

With universal life, you become underfunded by failing to have enough in the box to pay the annual mortality costs. Ultimately, the result is the same. The policy will be canceled for insufficient funds.

There are many reasons why advisors favor one type of insurance over the other. However, in the end, the box must have enough money to pay the mortality costs or you will be faced with paying them yourself.

Types of Insurance Policies

There are five basic types of policies: Whole life, Universal life, Variable life, Indexed life and Term life. Each has a distinct purpose and the decision regarding which will work best depends on your personal situation and goals.

Whole life—sometimes called ordinary life, straight life or permanent insurance— is a traditional insurance policy designed to help consumers handle the high cost of insurance in later years when premiums would otherwise become prohibitively expensive to match the increasing risk of death. By averaging out premium costs and amortizing them over the projected lifetime of the policy, whole life guarantees a continued death benefit for the insured’s entire life. The fixed annual premiums are usually level for the life of the insured and are based on the insured’s age and health at the time the policy is issued.

Universal Life – universal life insurance was developed to overcome the primary disadvantages of whole life insurance. It is another type of cash-value-building policy that provides extreme flexibility by giving the policy owner (i.e., you, your spouse, your children or your trustee) the ability to set and vary premium levels, payment schedules and death benefits, within certain limits. This increased flexibility makes it easier to adapt universal life policies to changing needs and financial conditions. Like whole life, a portion of each premium goes to the insurance company to pay for mortality—the “pure” cost of insurance. The amount of premium paid in to the universal life contract that exceeds the pure cost of insurance plus company expenses is credited back to the policy owner with interest.

Variable Life – variable life insurance offers all the flexibility that universal life provides but with a unique difference: Cash values are invested in a separate account instead of the insurance company’s general account, at the policy owner’s direction. The separate account is made up of a variety of pooled investment divisions that are similar to mutual funds. The policy owner chooses among the various funds offered by the insurer, so investments can be concentrated in a separate account of common stocks, bonds and other assets that are more volatile, but may provide higher long-term results than does an insurer’s general account.

Indexed Life – indexed life insurance, sometimes known as equity-based life, is another form of the previously discussed universal life. Actually, all universal life plans are, in essence, “indexed.” The vast majority are indexed to the general account earnings of the insurance company selling the product. The insurance company collects your premium, deducts some expense charges and cost-of-insurance (mortality) charges and, then, puts the rest of the money into its general premium investment account. Next, this account is invested by the company’s investment department, usually into several different types of investments.

Term Life – Many people have purchased term life insurance it because it offers substantial benefits at low cost. However, as its name suggests, term insurance is beneficial only for a specific period of time or term. For example, a term insurance policy with a decreasing face amount may be ideal for protecting a young family while there is a mortgage on their home.

Multiple Life Policies – most policies are written on a single life, but there are situations in which a policy can and should cover more than one life. A policy covering two lives is known as a survivor or second-to-die life insurance policy and is typically used to insure a husband and wife, to provide liquidity at the second death and to cover taxes and other expenses. A second-to-die policy could also be used in business situations.

How To Buy Life Insurance

Besides selecting the type of insurance and options you want, important considerations include how to find appropriate financial advice and how to evaluate specific insurance companies. In addition, you should understand how your age and health enter into the calculation of your premium and how the companies vary in their assessment of those factors in making insurance offers. There are many variables to consider before purchasing insurance.